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December 6, 2011

Jeremy Grantham Delivers Large Dose of Doom

Jeremy Grantham’s latest letter to clients is spectacularly, and relentlessly, depressing; but his oversight of $100 billion-plus in assets under management—on which he has bested the market by a significantly large premium—entitles the doomsaying hedge fund manager to a very respectful hearing.

Investors, Grantham (left) says, might want some valium—or travel visas—handy as they consider that the troubles plaguing the eurozone are “terrifying”; that economic recovery in the debt-plagued U.S., and the indeed the world, is unlikely any time soon; that developed world growth has “permanently” slowed because of long-term slowing population growth, aging and “an overcommitment to the old.”

But all that is just preliminary for the principal of Grantham Mayo Van Otterloo (GMO), who says the U.S. has become fundamentally uncompetitive because of “depleted infrastructure,” ineffective education and ineffective governance when it comes to tackling long-term issues.

Once investors can recognize there is a problem, Grantham stops mincing words: “We have gone from having been notably upwardly mobile during the Eisenhower era to having fallen behind other developed countries today, even the U.K.!” That was his first exclamation point. He reserves his second for “the most important and the most dangerous issues: depleting resources, development of a comprehensive energy policy, and, yes, global warming. Wake up dudes!”

But even environmental skeptics will want to pay close attention to Grantham’s market analysis, which helped his GMO Quality fund beat the S&P 500 by a whopping 9.1% in the first 11 months of the year in a relatively flat market while his balanced fund bested its benchmark by an impressive 4.2%.

In allocating his portfolios, Grantham has been looking at drivers such as rising profit margins and historically low inflation—according to which the market should be 20% higher. The model he and his associate Ben Inker developed suggests that market participants have been driving up stocks only when the “cloud of negatives” temporarily dissipates. Grantham believes the stock market is actually overpriced on the basis of long-term value, but has been investing according to this “behavioral model.”

Indeed, Grantham has a rather frightening view of a market that has been “overstimulated” for decades and which consequently has not been allowed to fall to its economically justified level. But because of central banks’ “wounded balance sheets,” the “arsenal is empty,” and the bust, when it comes, should be a doozy:

“When one of these old fashioned but typical declines occurs, professional investors, conditioned by our more recent ephemeral bear markets, will have a permanent built-in expectation of an imminent recovery that will not come” (Grantham's emphasis).

To prepare for what he projects could be a post-correction 14-year lull in stock-price appreciation, Grantham recommends ownership of just high-quality stocks; an emphasis on safety; an avoidance of duration risk in bonds; and, longer term, ownership of unspecified “resources in the ground,” though shorter term he sees price declines in resources as likely, as China and the world slow down.